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A Year Like No Other

We know 2022 was a tough year for markets. Modern portfolio theory is built on principles of diversification, which, in its indexed expression, delivered just about zero value last year. To put the year in perspective, notice how often both stocks and bonds have fallen sharply in the same year (bottom-left quadrant):

That bright red dot in the lower left is 2022. Unprecedented in the modern investing era.
We’ve been sharing our portfolio “remodeling” efforts over the past 18-24 months, and the potential for a 2022-type experience was the primary reason why we took the steps we did. This was especially true by the ways in which we reduced the exposure that the defensive side of our investments has had to rising interest rates and inflation. More recently, our specific portfolio changes in Q4 ‘22 are detailed at the end of this letter, so be sure not to miss that practical expression of our current thinking.

Revisiting 2022 Predictions

Reflect on one year ago. The closely followed Federal Reserve was forecasting a few small rate hikes to lift fed funds to 1% by year-end, and the average Wall Street forecast was for the S&P 500 to end 2022 above 5000. With the fed funds rate has risen from 0% to 4.5%, and the S&P 500 at 3800, should we care to spend much time studying the 2023 “expert” projections?

The lesson that should have been reinforced is that no one can predict the future, not even a team of insiders with PhDs. And we certainly shouldn’t invest with one specific state of the world in mind. The more prudent approach is to prepare for all scenarios, with thoughtfully constructed allocations using building blocks across a host of diversified return drivers.

Let’s start with a look at how the environment has changed, and finish with the current opportunity set for 2023.

A Different Era 

Legendary investor Howard Marks, age 76, co-founder of Oaktree Capital, recently wrote a memo called Sea Change, calling this the third large shift in his investing career. The first was in the mid-1970s when credit became an investable asset class, while the second took place in the early 1980s when the Fed crushed inflation and ushered in a 40-year tailwind of falling interest rates.

So, we take note of his insight that a shift is underway to a more discriminating environment, where due diligence gets rewarded at the expense of a passive approach. His visualization of this change:

We find his logic unassailable and coincides with the care we’ve taken over the past two years to position for the possibility of a changing environment. Not in a predictive way, just a commonsense way of evaluating the actual cash flows behind the investments we consider. And the interplay of those investments with one another.

What Can We Know Right Now? 

Investing is full of uncertainty, especially in the short term. In lieu of the guesswork of predictions, we’d like to share a few bedrock items we see in play:

  • The fall in stock and bond values sets up for better opportunities, both individually and across the market
  • Assets aren’t “cheap” by historical standards, but quality investments made at sane prices can be nicely profitable
  • The state of the economy is uncertain, but unlike in 2008 consumer and corporate balance sheets aren’t overleveraged

Some evidence to support each of these…

Opportunity Set

Lower prices don’t always mean better opportunities, but if prices fall more than conditions worsen, it’s often the case that future returns can be higher after the downturn. Across the board, we’re seeing incremental improvements to long-term projections like the following:

Source: BNY Mellon 2023 Outlook, page 11

And from a basic level, you’re probably well aware that rates on debt are at the highest in years. Bad if you need a refi, but better if you have savings to invest.


For virtually the entire time since the Global Financial Crisis, money has been shoveled into growth stocks. At times indiscriminately, as noted by Charlie Munger and Howard Marks above. But the new interest rate cycle has favored a more discerning buyer, focused on the price paid for an asset.

Balance Sheets

We don’t make housing investments on your behalf, but it’s undeniable that this area plays a key role in both the psychology and financial strength of consumers nationwide. While there may be pressure on prices due to the explosive rise in mortgage rates, we don’t face the same debt and supply issues that triggered the financial crisis.

On top of that, most outstanding debt is tied to (low) fixed rates versus the variable rates that can quickly threaten one’s ability to pay.

Portfolio Changes Made, Q422

Throughout the second half of the year, we continued the remodeling of our defensive sleeve with an eye toward reduced exposure to losses from rising interest rates.

We made two specific trades during the fourth quarter. We sold our position in gold and trimmed our position in an international equity manager. Both moves were to take some risk off the table in portfolios while we look for the macro picture to become clearer. We felt that both trades prepared us for a diverse set of outcomes – meaning the new purchases paid us to be patient through the interest on owning treasuries and we could also profit if stock markets rose through investing in hedged equity. Here is a summary of the two changes we made.

Gold to ST Treasuries: With the Fed’s aggressiveness in raising rates to combat inflation, the yield curve has inverted, meaning that rates at the front-end (think 3yr treasuries and less) are yielding higher than longer-term maturities (think 10yrs +). We moved some capital into a short-duration US Treasury ETF to collect these attractive yields, preserve capital through market volatility, and further decrease duration risk (sensitivity to interest rates).

International Growth to US Hedged Equity: The trade to trim our international exposure was in the face of continued geopolitical risks (Russia/Ukraine war, potential European energy crisis, and China’s Covid policies) and the continued impacts of higher interest rates on growth-oriented equities. We felt it made sense to transfer some of this exposure into US Hedged Equity. By making this change we could still profit if we saw markets rise (which we did in Q4) but be able to protect capital if the market would have continued its decline and volatility remained elevated.

One other trade we made back in Q3 that we wanted to highlight was the addition of the Inflation Beneficiaries ETF (INFL) into portfolios. This is an ETF that owns equities that traditionally have benefitted from elevated inflation, though do not require ongoing inflation to be successful. These are capital-light business models such as Transaction Facilitators (financial exchanges, brokerage firms, etc.), Royalty and Streaming Companies (energy, base metals, precious metals), Data and Research Companies (health care, insurance, energy, metals and mining, automotive and industrial), Timber, Agriculture, and Real Estate and Infrastructure Managers.

And finally, even though it might seem rather simple, we continue to help clients redeploy short-term cash reserves into the higher-yielding short end of the fixed-income market. Banks are often very slow to increase their interest rates so it takes a little extra work to place your resources into liquid money market funds and treasuries resulting in a nice 4%+ yield with little to no outright risks. Please be in touch if you need help on this front— we enjoy seeing you ‘get paid to be patient’ with your cash reserves.